Business

Aerospace and defense deal activity remains sluggish

Global aerospace and defense merger and acquisition activity remained down during the second quarter of 2012 compared to recent prior periods, according to Mission Control, a quarterly analysis of merger and acquisition activity in the global aerospace and defense sector by PwC US.

Smaller deals drove the majority of deal activity in the second quarter as large deals were impacted primarily by uncertainty about U.S. defense budgets and programs due to the unresolved U.S. sequestration issue.

There were 14 deals that were worth more than $50 million in the second quarter of 2012, more than a four-fold increase from the previous quarter’s total of only three deals. However, total deal value was only $3.7 billion in the second quarter. No mega deals (transactions worth more than $1 billion) occurred during the second quarter of 2012. With an aggregate deal value of only $5 billion during the first half of the year, merger and acquisition activity could be the lowest in more than a decade, even less than the height of the financial crisis if the second half of the year is consistent with the first half.

“One barrier to deal activity is the uncertainty about U.S. defense budgets and programs due to the unresolved U.S. sequestration issue, which is making it difficult for buyers and sellers to agree on value when there is uncertainty about the future cash flows of these businesses, resulting in a nearly complete absence of large deals,” said Scott Thompson, U.S. aerospace and defense leader at PwC. “However, once sequestration is resolved, most expect M&A activity to increase. Declining defense budgets may result in a wave of further consolidation, and therefore, many expect that a combination of economic forces and pent-up demand will drive deals after the sequestration matter is resolved.”

U.S. activity is down as defense companies in this market are directly affected by the budget uncertainty. The balance of deal making is shifting to the BRIC (Brazil, Russia, India and China) regions and emerging markets. BRIC entities accounted for almost 30 percent of deals worth more than $50 million in the second quarter of 2012, compared to only 15 percent of deals in all of 2011. Europe led inbound transactions during the first half of 2012 with four deals.

“Asia is gaining momentum in deal activity, which is consistent with growing defense budgets in the region, in addition to the ongoing growth of their domestic aerospace industries,” continued Thompson. “In addition, the relative weakness of the Euro may increase the potential that European targets will be a driver of activity in future periods.”

Aerospace targets, which benefit from a relatively high growth outlook compared to defense, drove more of the transactions so far this year. Motivations for these deals include the desire to benefit from the relatively high growth in commercial aerospace and a need to consolidate the supply chain in order to ensure financial strength that is sufficient to meet the requirements of the ongoing OEM production ramp up.

Cyber security and unmanned vehicles remain priorities for defense contractors, but defense companies are diversifying more into small industrial businesses. Many of these deals have small or undisclosed values and targets generally fall into areas such as government services, information technology and communications.

“The defense sector is entering into these new arenas to improve capabilities in markets with a more stable and higher growth outlook. Large defense companies may remain focused on small-scale merger and acquisition and organic growth through expanding foreign military sales, until there is more clarity surrounding the budget issues,” said PwC’s Thompson. “However, under the most bearish defense spending scenarios, significant horizontal consolidation among defense companies is possible and could lead to some historically large deals.”

Although cash levels remain high in the A&D sector, stock swaps have become more popular as a method for financing deals this year, reflecting the divergence in valuation as deal flow involves more aerospace acquirers than in the defense industry. In addition, the proportion of acquirers that are publicly traded has increased this year, which creates an option to use stock swaps that didn’t exist to the same degree as in the past.

“Overall valuations are down from last year, suggesting the caution of acquirers in the A&D sector, with multiples for defense targets generally lagging behind the sector average. This may not reverse if growth prospects between the A&D parts of the sector remain divergent,” said Thompson. “But, we are also seeing a rise in unsolicited bids, potentially driven by the increase in cash positions and relatively low valuations across the sector.”

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